Insights on how emotions impact our investment decisions
Behavioural finance explains how our emotions enter our investment decisions resulting in irrational decisions that are against our best interests.
Selecting your stocks
If you can’t find reasons NOT to invest in the stock, it will confirm your investment rationale.
Over-diversification
Investing in too many securities indicates your reluctance to commit yourself to just a few meaningful investments. Over-diversification results in de-risking your portfolio to an extent where meaningful wealth accretion becomes difficult.
Volatility
Volatility (sharp rises and falls in stock prices) is primarily the result of investment sentiment. Price volatility can throw up good bargains and exits.
Herd behaviour
Investors tend to follow the actions of a larger group.
Even if an investor is convinced that a particular stock should not be bought/sold, he might still follow the herd, thinking that they know something that he doesn’t.
By the time a herd investor learns about the latest trend, initial investors have already profited from the strategy. The herd investor enters when the stock is already over-priced and loses money while the initial investors have moved on to other strategies.
Being a contrarian investor can trigger fear, pain and pressure of non-conformity, but it will benefit the investor in the long term.
Losses – emotional pain
Losses hurt more than an equivalent amount of gains.
Investors focus too much on short term losses and less on long term gains.
Losses are so painful that investors prefer a small definite gain than the possibility of a larger gain with a concurrent possibility of a loss.
Being over-sensitive to loss can result in panic selling.
When an investor is faced with a loss, he will take greater risk to avoid the loss. ‘Averaging down’ the cost of investing in a stock whose price is falling, is a typical example.
Investors feel the pain of a loss incurred due to action taken more than pain due to inaction in the short term. Selling an investment, whose price rises shortly after selling, is more painful than holding the investment whose price falls, is a typical example.
Investors feel the pain of loss due to inaction taken more than due to action taken in the long term. Not having made an investment, which rose significantly over the years, in spite of a strong recommendation, is more painful than having made the investment and the stock underperforming, is a typical example.
Losses – instigate investors to take more risks
Investors sell winning investments too quickly and keep losing investments too long with the hope that they will bounce back.
Investors refuse to recognise a loss until they have booked it (sold the stock at a loss).
The urge to transact (buy/sell) intensifies after the investor books a loss or sees his investment portfolio in a loss.
Anchoring
You bought a stock at Rs.100; the price fell to Rs.80.
Don’t anchor yourself to your purchase cost (in this case Rs. 100).
Review every stock based on its current situation, profitability, prospects, etc.
Overconfidence
Most investors believe that they possess superior stock-picking skills. However, their belief is not justified by their portfolio performance. Remember, confidence is not equal to skill.
Men are more overconfident about their investment skills than women. However, studies show that women have generated higher returns than men.
Generally, overconfident investors conduct more trades than less confident ones, and earn lower returns than the market.
If you can’t find a good investment opportunity, you are better off doing nothing at all.
Optimism
Being optimistic is a good strategy for life; however, it’s not a good strategy for investing. Optimistic investors tend to take on more risks than they should without putting in sufficient effort to quantify the amount of risk.
Investors are addicted to information. Too much information leads to overconfidence and inaccurate investment decisions. Instead, analyse a few key aspects of an investment option to achieve superior performance.
Probability
The probability of a stock moving up or down is 50% in each trading session. Just because a stock has continuously moved up or down in several consecutive trading sessions does not mean it will move the reverse way in the next trading session.
Overreaction
Investors give more importance to new information/latest news and overreact to good/bad news; this results in sharp upward/downward moves in stock prices. Market players then realise that their optimism/pessimism was not entirely justified, which results in stock prices correcting.
Fear
Fear makes investors act irrationally. Panic selling and not recognising bargains is the result of fear.
Attachment
Don’t get sentimentally attached to your stocks. Make your selling decisions objectively.
Status quo
Inherited your father’s investment portfolio? Don’t want to change it out of love and respect for him?
In some situations, investors prefer to keep things as they are. The need to retain a portfolio inherited from a family member, is a typical example.
Consolidate
Keeping a separate trading and investment portfolio, a mutual fund and equity portfolio, a debt and equity portfolio, etc. will make no difference to your net wealth. Maintain one consolidated portfolio for easier management.
Predictions
You cannot use the past and the present as a base to predict the future.
Long term forecasting in the stock markets is near impossible due to the large number of variables impacting the markets.
Sharmila Ramnani
Sharmila is a Chartered Accountant by training and a NISM certified investment adviser. You can contact her on sharmila@financeinsights.com
You must be logged in to post a comment.